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The Long View
Scott Bondurant: Why Mean Reversion Means Your Portfolio Should Have More Stocks
00:53:07
The financial advisor and adjunct professor discusses elevated equity valuations, the limitations of random-walk assumptions, and why bonds are riskier than you might think.
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- [00:00]
Howard Capital Management Announcer
In volatile markets. The HCM byline keeps you grounded. Invest with confidence Discover Howard Capital management's funds@howardcm funds.com stay tactical not traditional investments in HCM funds involve risk, including possible loss of principal. There is no assurance that the funds will achieve their investment objectives. Investors should carefully consider the investment objectives, risks, charges and expenses of the HCM funds. This and other important information about the funds are contained in the prospectus, which can be obtained at www.howardcmfunds.com or by calling 770-642-4902 or 855-969-8464. The prospectus should be read carefully before investing. HCM funds are distributed by Northern Lights Distributors, llc. Member FINRA sipc. Northern Lights Distributors, LLC and Howard Capital Management, Inc. Are not affiliated.
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Podcast Disclaimer Narrator
Please stay tuned for important disclosure information at the conclusion of this episode.
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Amy Arnott
Hi and welcome to the Longview. I'm Amy Arnott, Portfolio Strategist for Morningstar. And I'm Christine Benz, director of Personal.
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Christine Benz
Finance and Retirement Planning for Morningstar.
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Amy Arnott
Our guest on the podcast today is Scott Bonduron. Scott is founder and Chief Investment Officer of Bonduron Investment Advisory, a registered investment advisor based in the Chicago suburbs. He's also an adjunct professor at Northwestern University, where he teaches an undergraduate course on the history of investing. He recently published a white paper about the importance of incorporating mean reversion in financial planning and portfolio construction, which we'll be discussing in this podcast. Scott has a BA from Stanford University and an MBA from Duke University's Fuqua School of Business. He started his career at Kidder Peabody and also worked for Payne Weber and Morgan Stanley before becoming a managing director for ubs. Scott, welcome to the Longview.
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Scott Bonduron
Thank you.
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Amy Arnott
So we wanted to talk about the concept of mean reversion and the paper that you've written about that topic and what it means for financial planning and portfolio construction. But before we get into this, we wanted to talk a little bit about your background. You were a top ranked tennis player when you were in college at Stanford and you spent a few years playing professionally after college. How did you end up choosing a career in business after that?
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Scott Bonduron
Well, it wasn't a straight path. So you know, when I played professional tennis I had a fairly clear eyed view that the odds on making it weren't really very good. The good news was I had pretty good grades and so I was thinking about potentially going to business or law school. I sat in some classes at Stanford Law and liked them and so I decided that's a good route to go and I ended up going to a year of law school and not liking it and then working at a real estate law firm, which was interesting in a lot of ways, but in the end it was a real grind and I kind of sensed that that was going to be the nature of a lot of the legal work that I might end up doing. So I look for greener pastures and talk to a few of my friends from college, one of which was an analyst at Wellington. And he invited me up to his offices up in Philly and showed me what he was doing and then took me to the trading desk where they were trading big blocks of stock. And I said that was pretty cool. And so the guy there said, well, you need to go to some of these Wall street firms and check in with them. And so I got very interested in the equity sales and trading thing, but the best way to get a job there was to get an mba. And so I went to Duke, got an mba, spent a lot of time, you know, on the job hunt and got an internship at Bear Stearns and then ended up getting a full time job in sales and trading for institutional equities for Kidder Peabody. So always good to be with the firm that, you know, we've been in the business long enough, these firms don't exist anymore. But so that's how I got going into the investment world. And so, yeah, that's kind of my story. And then I migrated to a few different things throughout my career.
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Christine Benz
We wanted to follow up on that. Scott, you started out, as you just said, working on the sell side at firms like Morgan Stanley, Paine Weber, Kidder Peabody. So how did you end up deciding to start your own investment advisory firm, which you run today?
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Scott Bonduron
Yes, so when I was at Morgan stanley in the 90s in institutional equities, it was just a boom time and just a ton of fun. So back in the day before the Internet, companies had to go through investment banks to basically tell their story and give investors an opportunity to understand what they're doing. And so we had a monopoly kind of on that information flow. And so we were able to obviously take advantage of that. And then the 90s when the Internet happened and people didn't really understand it, and lots of trading and activity, and we had basically groundbreaking research on it too, because we had the connections to the company. So that was a lot of fun. And I think I would have kept doing it if it weren't for what I say, three different things. So the first off is the Internet happened, right? And so everybody gets the information at the same time. And by the way, Reg fd fair disclosure happened and companies had to provide it to everybody at the same time. So we no longer had that age. Then there was electronic trading, so the spreads and the trading weren't as good. And finally Elliot Spitzer came around and made it so the very best analysts that were able to generate investment banking deals couldn't get paid for that. And so the very top talent, I think, left. So in many ways very good evolutionary reasons that became not as interesting a job. And what had started to happen in the early aughts was the new boom in hedge funds. And we were always encouraging hedge funds and they were big clients and profitable business and prime brokerage. And so I encouraged my clients to do hedge funds. And one of them, the legacy Brinson Partners, which was bought by UBS Global Asset Management, had an investment process they identified under and overvalued securities that lent itself to equity long short investing and said, yes, we want to do this. You come over and run it. So I did that for about 10 years and we built up a really nice business all over the world. And that was fun. Although at some point I think probably a lot of listeners can relate. But these big firms are very kind of challenging in a lot of different ways. And so I kind of got tired of the big firm and working for somebody else. And so I was in a position to take full career retirement. Having said that, one of the reasons I got into this business was trying to figure out if you have enough right. Using an Excel spreadsheet and speculative forecasts was not an easy task. So anyway, I did my best, said I think I got enough and took full career retirement, started teaching at Northwestern. I've taught the history of investing for over 11 years. And then I love the investment business and somebody said that they could bring me some clients. And so I got registered and started my own investment advisory firm. That pipeline for clients never happened, but I got going and you know, I love the business and you can tell, you know, from what I think we're going to talk about that I think there's a real opportunity to kind of, you know, do it better, if you will. So anyway, I've been doing that for seven years and have really enjoyed it and I've continued to do the teaching as well.
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Christine Benz
We want to follow up on some of the themes that you've just referenced, but I wanted to ask about Reg fd, which you referenced in your response. We had Charlie Ellis on the podcast not too long ago and he felt that Reg FD was absolutely seismic in terms of its impact on the investment management space and the active investment management space. Do you share that view?
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Scott Bonduron
Yeah, love Charlie Ellis, for starters. And yes, it was incredibly different, right. So there was a huge volume of information increase, and so people were better able to devalue securities. And I would also make a note that more and more people kind of became CFAs and were very rigorous about their approach to valuing securities. And so the whole thing got to be just much more efficient. So, yes, I think the. That was a huge moment for active management.
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Amy Arnott
You mentioned that you teach a course about the history of investing at Northwestern. What do you enjoy most about teaching?
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Scott Bonduron
So, a bunch of things. You know, one, it's fun to be with younger, enthusiastic people and kind of get a sense for the way they're looking at the world. And, you know, I also think that it's satisfying to be able to help them and, quote, give back a little bit. I kind of have set up this class as in many ways the class that I wanted to have when I was back at Stanford in college. And we had one class on the stock market with a guy, a broker, who came in from E.F. hutton. And it was fascinating to see how the real world worked. Right. And so I'm able to kind of bring that real world in. And by the way, I bring in guest lectures that are leaders in their respective fields and that are relevant for the particular class I'm teaching. And so they get, again, a broad view from a lot of different practitioners, and I think that's invaluable. So. And then lastly, it keeps me on my toes, right? And it keeps me fresh and, you know, have them read all the great books and I have to reread them every year to make sure I'm on top of it. There's always new things you learn. And so, you know, again, I love the investment business, so, you know, being able to dive in in a class. And again, it has impacted my view in terms of investing. In terms of looking at investing from.
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Christine Benz
The long run perspective, are there any lessons from market history that you think are especially relevant today?
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Scott Bonduron
Well, one that I would highlight is that when you look at the history of investing, it really is very much the history of speculations and boom booms and busts, and they kind of are consistent over the course of time, and I imagine they're going to continue to be. There's a great book, Devil Take the Hindmost from Edward Chancellor, that I have my class read, but walks through all of the bubbles from Tulip mania, the South Sea bubbles, to railroads to the Roaring Twenties to the Nifty fifty to the Japan asset bubble, more recently the Internet bubble, the housing bubble. And so, you know, while I would say that every market cycle is different and it's kind of important, there's a good reason why. So if you go to Vegas and you go to the different casinos in the craps table and you know, the blackjack table, there's a certain number of outcomes that are possible because you get 52 cards in the deck and two dice with six numbers on them. And so, you know, you can actually predict the odds very nicely in future returns. But you know, in the real world, it's always changing, it's always evolving. There's no parameters that are fixed. And so, you know, when we try and in general to make models that will help us in forecasting, there's a great line somebody had that said all models are wrong, but some of them are useful. And so I think it's really important to understand when you're looking at models of forecasting future, that they're all imperfect, but they're kind of as good as we can do if they're good models. Right. To help you in terms of expected returns. And the last thing in terms of more, you know, to your relevant question of how does it affect things now? You know, I would say that in a lot of ways I think this current AI driven market shows a lot of signs, classic signs of, of a bubble. You've got, you know, obviously a rapid price increase that, you know, always happens in bubbles. You've got all sorts of investors doing speculative things and you only have to look at the inflows and delivered long ETFs, you know, cryptocurrencies, SPACs again, et cetera, to kind of see that. And high beta stocks outperforming. There's easy access to capital. I mean, there's so much money, billions and billions obviously being spent on AI. So there's tons of that, there's tons of media hype and public enthusiasm. This is what happens. We've got intense media coverage and social media buzz, et cetera. And then valuation metrics aren't so relevant. If you look at the S P500, all of the valuation historical value metrics are extremely expensive and obviously driven by the biggest names in AI. And then know there tends to be this new paradigm thinking it's different this time, the old rules don't apply and a certain overconfidence in new technologies and business models. And all that leads to eventual unwinding. So I would be cautious in terms of the current, you know, S&P 500 and US markets. And the last thing I'll just say is that for investors, personal investors, never underestimate the power of compounding and the benefits of cost averaging, dollar cost averaging. So, you know, you've got to, I guess, talk about that. But Einstein said compound interest is the greatest mathematical discovery of all time. And I think he's right. So, you know, people need to be well aware of that now and in the future.
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Amy Arnott
So in an environment where there is a lot of speculation and potential bubbles in the market, how should investors respond? Is there an argument for pulling back on equity exposure or just trying to be more cautious about not getting caught up in fear of missing out and things like that?
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Scott Bonduron
So I'll enter a couple different ways. The modeling I do when markets are overvalued, it says, yes, that you ought to be kind of reducing your allocation to overvalued equities in favor of more bonds and bills. But I would tell you that this market, you guys know is very unusual, right? So there's a large part of the market that is reasonably valued or attractively valued. So we're believers in looking at the markets globally. And markets outside of the US Are reasonably priced in their equities. Value tends to be underpriced and attractive in a lot of areas. In the U.S. small caps are, we think, very attractive. So we can find places, and we have our clients in equities that are reasonably priced, that we think will get a historical return. So that's the way we're. We're addressing that.
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Amy Arnott
So we wanted to transition into the whole topic of mean reversion. And this is a key concept that you incorporate in your practice. And you've also written about why you think the idea that market returns follow a random walk is flawed. When and how did you first start getting interested in this topic?
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Scott Bonduron
I think I read Siegel stock for the long run about 25, maybe 30 years ago, and it always kind of stuck with me that there seemed to be a lot of logic in that, that, you know, basically if you hold stocks for long periods of time, not only do they do well because they've got higher expected returns, but they're really not nearly as risky as generally perceived. And so that's always something that I've had, and I generally followed, you know, personal investing. But then when I got to doing my own investment advisory and really trying to figure out how to advise people in A really rigorous and intelligent way. It was quite frustrating for me. I was convinced of the stocks mean revert. There's lots of really good academic literature out there would note. Thaler and Spiegel in like 1998 put out a study about how in a one year time frame, volatility of stocks are kind of 18% in bonds, 10 year treasuries about 5 or 6% but over a 20 year holding period they really have very similar levels of that. And then there's Chiller did seminal work way back when on this whole notion that stocks are much more volatile than the underlying values. And he looked at dividend paying. But basically again there's a lot of literature out there. So I was very convinced that this was a real thing and I was encouraging clients to do it. But I didn't have a systematic way to go about trying to incorporate mean reversion into the financial planning and portfolio. So I went about looking up all the old data and Shiller's got a site that goes back to 1881 for monthly returns in the US for stocks, bonds and bills. And I had a friend who's you know, much smarter than I am, I'm not a financial engineer, but had experience in block bootstrap methodologies for using Monte Carlo's which enabled long term holding periods to incorporate. So the first conclusion was that it was very clear, looking at the expected returns that stocks do mean revert over time and very powerful. And then we wanted to figure out, well, at different asset allocations and different withdrawal rates, how would that impact people over the course of time. And we got pretty far down the path. And then we got wind of what GMO Jeremy Grantham's firm was doing, identifying the same anomaly. And they've created something called Nebo, but they have developed a formula that takes historical returns and incorporates them into a mean reversion simulation through Monte Carlos. And so we took that formula and were able to do a whole lot of simulations comparing random walk with mean reversion and getting very robust outcomes in terms of understanding probabilities of not going bust, probabilities of ending assets and sizes of losses drawdowns. And so those are really, really powerful findings. We think so that's kind of the evolution of the paper.
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Christine Benz
You write that there are both fundamental and behavioral reasons why stocks mean revert. Can you expand on what some of those reasons are?
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Scott Bonduron
Yeah. So fundamentally there's a lot of forces that force companies and markets towards mean reversion. So basically companies or industries that come up with new better solutions or most often new technologies that they can take advantage of. They get unusually high profits and very high valuations because of that. But the reality is when that happens, it attracts a lot of capital into the marketplace. You can get a lot of competitors and ultimately, you know, if there's an oligopoly or monopoly, you've got regulatory potential. Things that happen that, that basically cause profits and companies, you know, fundamentals to revert kind of the mean over the course of time. And the same thing goes on the other side, right? So if, if you've got an area or industry that, you know, it becomes very unprofitable, you know, a lot of players just leave the field. There's no more capital coming in until you get a level where the players that are left are actually quite profitable and they're running good businesses. And so again, their fundamentals mean revert back to that. But I think the more important thing really is the, is the behavioral. And I think again, people just get really excited about the new technologies in particular. Again, this is the whole list of things that I kind of talked about at the beginning about speculations and prices get way out of whack and well above fair value. And eventually we get that corrected and prices move back to fair value. And oftentimes, right, they'll overreact and you'll get to times when you're pricing things well below fair value. And again, that will mean revert over the course of time as well. So number one, I would just say mean reversion is in the numbers, right? And so I think there's ways to explain it, you know, considering fundamental and behavioral, you know, rules. But I think there's no denying the numbers.
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Amy Arnott
So how long does that process usually take? If stock valuations are either overvalued or undervalued, how long does it usually take for things to kind of self correct and get back to the mean?
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Scott Bonduron
That's the million dollar question, right? So the answer is a long time. And so, you know, it's different, you know, every time. All that said, we use about a seven year mean reversion timeframe. That's I think a reasonably good average. But you need to know that that is a just kind of a point amongst what is no doubt going to be a wider variation.
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Christine Benz
You referenced Robert Shiller earlier and we wanted to follow up on the cyclically adjusted PE ratio. We've seen some research suggesting that the CAPE can be a useful directional indicator. But there have also been times when capes have remained elevated for an extended period. Such as during the 1990s and more recently. So how do you avoid getting false positives about the market's valuation level?
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Scott Bonduron
So it's a good question. So basically we like the Cape because It looks back 10 years, so it does take into consideration different parts of the cycle. And so we think that that is a solid way to look at earnings over the course of long periods of time. It's been a very good indicator in not only the US but internationally and that's really, we find probably the best long term indicator. One other thing I, I would just worth noting on the, on the Cape earnings is that they also of the reasons we like it is they use reported earnings. And so right now the trend obviously as you know, is it's gone to pro forma earnings. I think 95% of companies in the S and P use pro forma earnings and essentially they overestimate their earnings because all the one time losses they kind of write off. And so we think it's actually a more robust number using reported earnings because in aggregate the s and P500 has lots of write offs every year that should be incorporated. So back to your question. There's a couple of things that are worth noting right now. I think the cape is like 38 times and historically it's been at 16 times on average going back to 1881. We would note that there is over the course of time a consistent increase in the CAPE pes and that's because economies and markets and perhaps regulatory regimes become more stable and therefore people are willing to pay more. And so we think there's some logic to that. So when we were running our models on valuation, I think we've used a 20 PE and undervalued 25%, overvalued another 25% on the other side. So but you know, to answer your kind of question, it's again, it's another million dollar question, right? So is it different this time? Are the profit margins that we've seen in recent years because of the increase in technology as a percentage of the profitability of the S and P, does that mean it's different this time? And the answer is maybe a little bit. But historically there's all sorts of reasons and history shows that it's different this time really doesn't play out. And so we think it's as good a metric as there is. And so again, if we can find capes for different parts of the market that are reasonably priced in that kind of 16 times level, we're pretty comfortable. And we don't really want to take a risk at the 38 times because history shows when valuations, Cape valuations are high, you get lower returns. When CAPE valuations are low, you get higher returns, enormously consistent over time. And we're not sure that's a good reason to think it's different this time.
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Amy Arnott
So it sounds like you would argue that even if we don't go back to an average CAPE of 16 times, stocks are probably still pretty overvalued in the US at the moment.
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Scott Bonduron
That's the way we look at it. Yes. In the s and P500. Yeah.
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Amy Arnott
And on the fixed income side, you also talk about bonds tendency to mean avert rather than mean revert. Can you unpack what that means?
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Scott Bonduron
Yeah, it's a really interesting phenomenon. So again, when you go back and look at the data, bonds show increased volatility relative to the standard random walk methodologies would indicate. And so the question is, okay, well why is that? And you know, there's a couple reasons. One that are worth pointing out. Stocks, when you have unexpected returns, their future returns have a negative correlation. So when stocks do really well, future returns don't do as well. And the stocks are really badly future returns are better, so they're negatively correlated. Interestingly enough, when bonds have unexpected returns, really largely due to inflation, their future returns are positively correlated. So that's increasing the volatility. And basically historical periods of inflation tend to have persistency. So basically the idea there is that bonds are more risky than you think. And another way to look at that is to say there are periods of massive volatility within bonds. So the 10 year in the 21 to 2 year period in the 2122 timeframe lost 30% in real terms. And bonds, they don't have the possibility of kind of these exponentially large returns on the rebound that equities do. And so when you lose that much money in real terms, it's very hard kind of to make it back up. And that's because there's quite a bit of volatility. So another point worth making.
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Howard Capital Management Announcer
In volatile markets, the HCM byline keeps you grounded. Invest with confidence. Discover Howard Capital management's funds@howardcm funds.com stay tactical. Not traditional investments in HCM funds involve risk, including possible loss of principal. There is no assurance that the funds will achieve their investment objectives. Investors should carefully consider the investment objectives, risks, charges and expenses of the HCM funds. This and other important information about the funds are contained in the prospectus which can be obtained at www.howardcmfunds.com or by calling 770-642-4902 or 855-969-8464. The prospectus should be read carefully before investing. HCM funds are distributed by Northern Lights Distributors, llc. Member finra, sipc. Northern Lights Distributors LLC and Howard Capital Management, Inc. Are not affiliated.
- [29:21]
Christine Benz
You earlier referenced trying to figure out whether you had enough to retire and how that sent you down the road of investigating various aspects of retirement readiness. So maybe you can talk about why standard Monte Marlowe based retirement software, which is based on the random walk assumptions, why that leads to withdrawal rates that tend to be overly conservative in your view.
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Scott Bonduron
Yeah, so I'll step back and I think it was 1952 that Harry Markowitz basically came out with his modern portfolio theory. And I teach a class on it. It's seminal in the history of investing. He basically kind of said, hey, people haven't systematically thought about diversification and here's way to measure it and incorporate it in future expected returns. Just really powerful. And the mean variance optimization that he used basically said that they incorporated a random walk. And so let me talk a little bit about what the heck is a random walk, right. Versus mean reversion. So if you think about a coin toss, you know, you flip a coin five times, it comes up heads five times in a row on the sixth toss, what are the odds on it coming up heads for tails, right? So the answer is 50, 50. And that's because past returns don't have any influence on the next flip. And so that means that the next flip is random. And so that essentially is a very good use of, you know, risk measurement for coin flipping using a random walk. That said, it really does not properly reflect the way equities returns have been and I think will continue to be because it doesn't reflect mean reversion. So the idea there is that if again, you know, stocks go down by 50%, historic return data says after they're down 50%, they're going to return more than normal until they get back to kind of fair value. Similarly, if they go up by 50% on a future basis, they're likely to return less. And so there's a mean reversion component to that. If you were to in the way mean variance optimization works is they say if the market's down by 50%, the average return of stocks over 100 years is somewhat like 10%. So if you use 10%, they'll say after 50%, you're no more or less likely to have a 10% return. And so you've got the possibilities of much larger tails. Right? So after you have big moves, they can continue to go in that direction because there's no influence of mean reversion. And so what ends up happening is that when standard modeling takes place and you kind of say, well, what are the chances of going bust in a given model, financial model, they'll use random walk. And what they'll show there is that high equity portfolios have this huge potential spread and therefore you're more likely to go bust. And so the answer for an advisor looking at that is to say, well, I'm going to use less equities. Or you tell your client to have lower withdrawal rates. And so if you use less equities, you're going to get lower returns. And it's suboptimal. And actually, if you use mean reversion very often, you'll find that the existing withdrawal levels are just fine and have a very manageable chance of going bust. And so it basically the argument, you know, that we believe is if you don't incorporate mean reversion, if you just use random walk, you're going to get flawed results.
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Amy Arnott
So it sounds like if you do incorporate mean reversion, you would generally end up with a higher equity allocation during retirement. Does that higher stock exposure lead to more sequence of returns risk, and how do you mitigate that risk?
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Scott Bonduron
Yes. So, you know, I don't want to be, you know, at all flippant about, you know, high equity portfolios and bear markets. I think currently there's, you know, less concern than there should be about that. So the answer is yes. If you retire and have a high equity portfolio in the very early periods of retirement years, you get a major bear market, then your chances of going bust go up very substantially. So how do we address that? A couple of ways, most importantly is for our clients, we make sure everybody's got three years of either cash or visible income coming in for spending needs. And so it's very interesting when you look back at the history of bear markets going back to the 20s, the average time it takes to go from a bottom of a bear market to a new high is 3.3 years. So if you end up kind of having three years of cash, what you're able to do is not sell stocks during bear markets to replenish your cash levels. And if you have three years, you're in a pretty good position. And frankly, we are more interested in just making sure that clients don't sell during bear markets. And so the Time it takes to go from a bottom of a bear market to not being in a bear market as opposed to new high is something like 1.7 years. So we think three years is a pretty good cushion. And there's a, you know, a behavioral benefit to that as well. So that's the way we kind of look at the sequential return risk. And the other part of it I would just say is the numbers are the numbers. You can have negative, there could be negative periods in the bond market and that sort of thing too. You lose real value. And so we think our models showing different asset allocations kind of give you a real sense including the times when you get hit early with bear markets.
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Christine Benz
What's a typical safe withdrawal rate if you assume a 30 year retirement period and incorporate mean reversion for the return paths.
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Scott Bonduron
So first off, I just start in saying that it's really important that people that are really planning for retirement have their own financial plan and it's customized to their world. And a few thoughts there. One, if you've got a plan, you know, if you've got assets that are in IRAs, you're going to get RMDs and the taxes are going to be a big influence. If you've got big capital gains when you sell them, you're going to have, you know, big tax effects. So there's, you know, one size doesn't fit all the other part of it that I'm careful about in terms of individuals is a lot of people are quite comfortable with lower withdrawal rates and we can talk more about that. And I do want to talk more about that and the kind of Brian Portney view of the world in terms of wealth and happiness. So I'm not, you know, everybody's a little bit different is all in terms of what the correct withdrawal rate is. But I would say to answer your question, long winded, as a rule of thumb, we find that in the work that we did, an 8515 equity portfolio and a 5% withdrawal rate leads to, I think it was a 7% chance of going bust, which is pretty reasonable. So anyway, that's kind of a decent rule of thumb from our vantage point.
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Amy Arnott
So you mentioned kind of the body of academic research that does support the notion of mean reversion. But at the same time, I think almost every retirement software provider still is based on random walk assumptions. Why do you think that is?
- [37:36]
Scott Bonduron
It's a really good question and I'm hopeful over time it will change. But I think there's a bunch of things, I mean One, a lot of this software is driven by institutional investors and there tend to be much more short term in orientation. So I, you know, quants in a lot of ways as, you know, kind of derive trading in the marketplace. And so mean reversion doesn't come into consideration in their investment time horizons. And then, you know, your traditional active managers, they're trying to outperform every year, right? And so, you know, if they have three bad years, they'll tend to get fired. So they can't afford, you know, they don't have the luxury of saying let's look at this for the long run, right? And it's a seven plus year thing, right? And so I think that there's just a lot of. And by the way, mean variance optimization is a really easy to use and everybody uses it and it's the standard and it's like, you know, it's all good, right? So, you know, I think there's just a lot of inertia. The last thing I would tell you is that I think it's very hard for a lot of the traditional financial advisory firms, brokerages, et cetera to say that we've been telling you 60, 40 is the optimal portfolio for a long time, but actually it turns out that we weren't looking at things right. And so you should move to 85, 15. That's a very hard thing to do. And so it's been interesting, the guys at GMO that are promoting using this meaner version, they have found that the area where they're getting interest is registered investment advisories. And that's largely because, you know, they're their own bosses and they don't have a kind of forced methodology from the top. But there's starting to be, I think, a decent amount of conversation in the marketplace about trying to figure out how to incorporate mean reversion. And I do think that things will evolve because it makes a big difference in terms of what kind of financial plan and what kind of portfolio construction that people have. So I think it's important enough where it will happen over the course of time.
- [39:58]
Christine Benz
Do you think there's kind of an industry bias toward underspending? Because obviously advisors don't want to risk having their clients run out, but also sort of a motivation to preserve the assets that generate fees. Do you think that, that that might be feeding into this tendency to lean into the strategies that encourage underspending?
- [40:22]
Scott Bonduron
Sure. Right. So look, advisors are incented, right, to keep the business, right? That's the incentive. And so, you know, the times when they're likely to kind of get fired. Right. Are if things don't go well with that financial plan. So there's an incentive a couple fold, one to keep people spending less and so there's not a risk of going bust or reduced risk. And then the other part is they're also incented to kind of promote the 60, 40 and lower equity portfolio because there's less drawdown risk. Right. And so in the short term, you know, you're not going to have to face your client and say, gee, you're down by 50%. You do 60, 40, you say, you know, we've participated in the upside nicely and then when the market goes down, you know, we protect it. So you know, those are I think behavioral reasons why I think advisors kind of, you know, do the things they do, including encouraging lower spending.
- [41:26]
Amy Arnott
You mentioned the Nebo software platform from GMO which does incorporate mean reversion. How does that work at kind of a practical level? Does the software use current market valuations to set return assumptions and then also incorporate some sort of time period where future returns revert to the mean?
- [41:49]
Scott Bonduron
Yeah, so it's a really sophisticated system that works really well. So we start with the basic cash flow modeling from we use E MONEY because it's very granular and again, if you're forecasting 20, 30 years out, you better get good data in there. And so what we then do is take those cash flows and put them into the Nebo models and they're able to come back and kind of say, here's the probabilities of going bust, here's the likely return given various asset allocations, here's the likely drawdown that your clients are going to have to accept. And then in terms of the inputs, it's very modular. So we put our own kind of inputs in terms of the expected returns for the different investments, be it stocks, you know, bonds or bills and then, or frankly they're also very flexible. We can use private equity and that sort of thing and we can, we can put different, you know, expected returns, correlations and volatility is in there. But we may want to get to that later. But the point of the matter is what we do, what we do is say, hey, we think this category, say small cap international value is undervalued. So we're going to get excess returns for a seven year period. Right. And then we're going to get the normal returns. And it does that for, you know, all of the different inputs. So there's a. Yes, exactly what you said. There's a seven year reversion period and then you just kind of have normal returns after that.
- [43:34]
Christine Benz
Another topic you discuss in the paper is why standard risk tolerance questionnaires don't always do a good job of measuring clients actual risk tolerance. So what is a better way for advisors to get a handle on how much risk their clients can tolerate?
- [43:52]
Scott Bonduron
Really good question and challenging. So the way we try and do things is say let's try and provide an optimal portfolio that provides the most utility to investors or clients for balancing their goals, right, of not wanting to run out of money and probably being able to live well and hopefully give away some money at end of life to generationally or to charities. So we try and assume that they are, you know, when we create this quote, optimal portfolio for them, that they are very rational. And so we spend a lot of time up front, you know, kind of explaining what it is we do, why we do it, you know, the empirical backing for it and trying to get a lot of buy in up front. Part of that is we tell them you are likely to have, you know, their bear marks are going to happen, you're going to have significant drawdowns. And so when they do happen, you kind of say, you know, this is, this is kind of what we talked about and we can, you know, run a new model from there in terms of what your chances of going bust are, et cetera, et cetera. So you know, I think mostly that's the most important thing, that you get them comfortable. That kind of like this all makes sense and I'm going with it. All that said, you know, there's some counterintuitive parts of that. So you know, for a lot, and our work in the paper shows this for investors, they're more likely to go bust with portfolios that have low levels of stocks than, you know, they are with higher level of stocks. And a lot of that is simply because the power of compounding equities over time and then that again, you know, the volatility and chances of actually losing money in bonds. So in the end, if you look at the traditional models for measuring risk tolerance or questionnaires, they're kind of very tilted towards how scary you of drawdowns and how much risk are you willing to take. And so I think it's really important that you have a robust questionnaire. We use a modification to CFAs. I think the Morningstar one is really good as well. And you try and get a sense of what the sophistication of the investor is, whether or not they actually sold stocks if they were around in 2000 for the Internet bubble or the financial crisis or in 20 with the pandemic. And so you get more of a real sense of that. And then we ask them, does it make sense to you that you're willing to take meaningful losses if it gives you a better chance of achieving your goals? So I would just say in the industry, I'm very concerned that the industry outsources their portfolio management to the risk tolerance questionnaire. And inevitably the risk tolerance. And I think there's quite a bit of studies in this that come back saying most people are in the middle, right? They want to take some risk and get returns, but they don't want to take too much risk and be concerned about losing it all. And so because, you know, advisors kind of don't want to get sued, right? They say, okay, we'll give you a 6040 portfolio, right, or some modification of that if they've got a higher risk tolerance or lower risk tolerance. And frankly, that's, in our view, a suboptimal way to give advice to people. And you're not really best serving your clients by that sort of methodology.
- [47:25]
Amy Arnott
It's kind of counterintuitive that you could actually end up with higher probability of running out of assets if you're overly heavy on the fixed income side.
- [47:35]
Scott Bonduron
And it's very clear in the data, right? And so it's really remarkable. And just again, using historical data. And so it's very counterintuitive. And that's why it's another reason why it's kind of perhaps harder to accept, right? Broadly, because we're all very conditioned towards high equity portfolios, give you a better chance at blowing up and not making it. So anyway, it is counterintuitive.
- [48:01]
Amy Arnott
So we also wanted to ask you kind of a lighter weight question. You're still an avid tennis player and you previously served as president of the American Platform Tennis Association. I think a lot of people and probably our listeners are familiar with pickleball, but might be less familiar with platform tennis. Can you give us a quick primer on what platform tennis is and what kind of people might enjoy picking that up as a sport?
- [48:34]
Scott Bonduron
Yeah, platform tennis is awesome. So it basically was invented in New York in the late 1920s before indoor tennis and tennis players, you know, in the winter were trying to get some exercise. And so they essentially put a net on a back porch so the balls wouldn't go by. And then they started playing off the nets. So playing off the screens that stop the balls from going into the snow and that sort of thing. So you end up with this game that's kind of a mini tennis, if you will. It's about third, a quarter the size of a tennis court with these chicken wire screens around it so you can play off of the screens. And most importantly, this is a sport designed for winter warriors. So there's heaters underneath and, you know, if there's snow and ice, everybody goes out and plays. And it's one of the very few things you can do in the outdoors in winter and in, literally in Chicago, there's an enormous, you know, popularity in terms of league, and there's 10,000 people playing league paddle and in Chicago. And it's enormously popular, really, in all northern climbs, essentially. And the other wonderful addition to the sport has been, you know, what we call these Taj Mahats, but basically they're mini sports bars next to the paddle court. So you finish and it's just everybody kind of goes in and drinks beer and, and socializes, and that's part of the game. So it's a fabulous, you know, sport that way and just, just a lot of fun for folks in the winter.
- [50:12]
Christine Benz
Scott, it sounds like you have a pretty busy life with teaching, running your own advisory firm and playing both tennis and platform tennis. Do you have any plans to retire yourself?
- [50:24]
Scott Bonduron
So you spend a lot of time on this question of happiness in retirement. And I have two. And again, Brian Portnoy, I think, you know, the geometry of wealth is a fabulous way of kind of looking at, well, number one, this whole distinction between rich and wealthy. So the whole idea of chasing more money and becoming rich or being rich and chasing more money is, is the hedonic treadmill and not great. But, you know, what you want to be is wealthy. And you, you basically want to do stuff that you really enjoy and have a lot of autonomy and, you know, get a really good sense of community and hopefully you're doing something that is helping, you know, society more broadly. And so I kind of think I've been able to do this. I take a. A very long, you know, I've got my own company, so I'm doing my thing. I take a very long view in terms of investment horizons, and I appreciate being on the Long View podcast because I think it's very applicable in terms of mean reversion, how that works. So, you know, I'm not looking to figure out what's going on in the markets every day and trying to react to that. So it's, I think, quite manageable. And I really love it. So I love playing paddle. I play a lot of actually still playing some competitive senior tennis and I love teaching so I'm happy to continue to do that. I think I can do it for a long time so we'll see.
- [51:51]
Amy Arnott
Well, thank you so much for joining us. It's been great talking with you and definitely gave us a lot of food for thought.
- [51:59]
Scott Bonduron
Thank you and I appreciate your inviting me on. I'm an enormous fan of this podcast and your book on retirement planning, so I'm honored to have been a guest. So thank you very much.
- [52:12]
Christine Benz
Thank you so much Scott.
- [52:18]
Amy Arnott
Thank you for joining us on the long View. If you could please take a moment to subscribe to and rate the podcast on Apple, Spotify or wherever you get your podcasts, you could follow me on social media, Amy Arnott on LinkedIn and.
- [52:34]
Christine Benz
Ristinebenz on X or Christine Benz on LinkedIn.
- [52:40]
Amy Arnott
George Cassidy is our engineer for the podcast and Carrie Gretchik produces the show Notes each week. Finally, we'd love to get your feedback. If you have a couple or a guest idea, please email us@thelongvieworningstar.com until next time. Thanks for joining us.
- [53:00]
Podcast Disclaimer Narrator
This recording is for informational purposes only and should not be considered investment advice. Opinions expressed are as of the date of recording and are subject to change without notice. The views and opinions of guests on this program are not necessarily those of Morningstar, Inc. And its affiliates, which together we refer to as Morningstar. Morningstar is not affiliated with guests or their business affiliates. Unless otherwise stated. Morningstar does not guarantee the accuracy or the completeness of the data presented herein. This recording is for informational purposes only and the information, data analysis or opinion it includes or their use should not be considered investment or tax advice and therefore is not an offer to buy or sell a security. Morningstar shall not be responsible for any trading decisions, damages or other losses resulting from or related to the information, data analyses or opinions or their use. Past performance is not a guarantee of future results. All investments are subject to investment risk, including possible loss of principal. Individuals should seriously consider if an investment investment is suitable for them by referencing their own financial position, investment objectives and risk profile. Before making any investment decision, please consult a tax and or financial professional for advice specific to your individual circumstances.
- [54:32]
Scott Bonduron
Sam.